Student Loan Bankruptcy: A Double Whammy

by Alyssa Oursler | October 8, 2013 10:43 am

The government shutdown has put a lot of important reform on the back-burner. The student loan proposal that President Barack Obama released in August, made headlines for just a week or two before the back-to-back Syrian and shutdown crises stole the spotlight.

And with the budget battle still raging on and the debt ceiling crisis on deck, there’s little reason to expect progress anytime soon.

Not only do several key pieces of the proposal require Congressional action — including the expansion of income-based repayment — but the administration’s sweeping “Race to the Top” requires Congress to appropriate funds to a new program. And for the cherry on top, student loan bankruptcy wasn’t included in Obama’s plan to begin with because it relies solely on the legislative process.

That’s bad news, because student loan bankruptcy laws are a huge double whammy for borrowers as they stand now.

A Different Set of Laws

Student debt could be discharged in bankruptcy until the 1970s, when the first restrictions were passed on federal loans in part to prevent new graduates — especially highly indebted grads from law and medical school — from declaring bankruptcy immediately instead of repaying their loans.

In 2005, those laws were extended to private loans — which often do not offer the same flexible repayment plans as their federal counterparts — and now all student debt must pass an extremely rigorous “undue hardship” provision in order to be discharged.

This remains the case even as default rates are at their highest level in nearly two decades, according to numbers released last week from the Department of Education. One in 10 recent borrowers defaulted on their federal student loans within the first two years, while that number drops to one in seven when measuring defaults for the first three years of required payments. And $52 billion in student loans shifted from current to delinquent during the first half of 2013 — the highest six-month tally recorded since 2003.

On a side note, credit-card delinquencies — which can be discharged — have fallen to their lowest rate in 19 years.

The Cost of Bankruptcy

The current difficulty in discharging student loans is problematic on many levels. The most obvious casualty is a borrowers’ credit score, where damage can last a lifetime and even hurt job prospects in some cases. Plus, that burden is the last thing the up-and-coming generation (and broader economy) needs, considering many recent grabs are already holding off on big-ticket borrowing for items like houses and cars, and lending standards have already been tightened.

The current system is also something of a self-fulfilling prophecy, according to Joe Valenti, the Director of Asset Building at the Center for American Progress. “The difficulties in discharging student loans through bankruptcy also suggests to lenders that these loans are a safer bet than others, such as credit cards, so there is an incentive to fund higher education through lending instead of other means,” Valenti said.

The pile of student debt, which is approaching $1.2 trillion, is a clear testament to that reality.

But the cost of strict student loan bankruptcy laws doesn’t end there. Consumers who do file for Chapter 13 generally end up owing more on their student loans at the end of the process, according to a recent report in The Wall Street Journal[1].

“The process under Chapter 13 of the code generally restricts borrowers from making full payments on student loans during the three-to-five-year bankruptcy period,” Katy Stech explained. “That allows lenders to add interest, late fees and other penalties to the student-loan balances during that time.”

No Solution In Sight

The small bright spot: Because student debt bankruptcy is a multi-layered problem, addressing it can also be a multi-layered solution. “Bankruptcy reform is another tool to enable students who are struggling with high levels of education debt — and potentially unable to ever pay it back — to get a fresh start just like any other debtor,” Valenti at CAP explained.

On top of that, the bankruptcy reform CAP is pushing[2] has many of the same outcomes of Obama’s plan, yet doesn’t require new funds. “A system of qualified student loans, including bankruptcy reform, creates market incentives for institutions to provide high-quality programs at affordable rates,” he said.

Unfortunately, Valenti also added that it’s “highly unlikely any changes to the treatment of student loans in bankruptcy could take place outside the legislative process.”

And for at least the immediate future, that legislative process remains at a standstill.